Tarun Singh

TF: Andres Zahler

Ec 10 Problem Set #6

1. The fact that 43% of consumers planned to spend the extra

disposable income even though their long-term income
expectations were unchanged suggests that consumers may only
loosely follow the permanent income hypothesis. However, there
may be other factors at play here. For example, suppose
consumers expect price levels to rise and real interest rates are
low, it would make sense for consumers to spend more of the
extra disposable income today rather than tomorrow.

2. a) The Aggregate Demand curve has a downward slope because

as price level rises, nominal GDP rises. The increase in nominal
GDP causes an increase in money demand because people need
more money for everyday transactions at higher prices. The rise
in money demand causes an increase in the interest rate since
we assume MS is unchanged. Higher nominal interest rate means
real interest rate is also higher. Higher real interest rate causes a
decrease in consumption demand since people substitute away
from spending and towards saving. NX also decreases since
higher real interest rate increases the real exchange rate. It also
reduces investment demand because the net present value of
investment opportunities is reduced. Thus, at higher price levels,
aggregate expenditure is reduced and so the AD curve slopes
downward.

b) The SRAS curve slopes upward for three main reasons. First,
lower price levels cause misperceptions about relative prices,
and these misperceptions induce suppliers to respond to the
lower price level by decreasing the quantity of goods and
services supplied (misperceptions theory). Second, because
wages do not adjust immediately to the price level, a lower price
level makes employment and production less profitable, which
induces firms to reduce the quantity of goods and services
supplied (sticky-wage theory). Finally, because not all prices
adjust instantly to changing conditions due to menu costs, an
unexpected fall in the price level leaves some firms with higher
than desired prices. These high prices depress sales and induce
firms to reduce the quantity of goods and services they produce.

c) The LRAS curve is vertical because in the long run, an

economy’s production of goods and services depends on its
supplies of labor, capital, natural resources, and available
 technology used to turn the factors of production into goods and
services. Changes in price level do not affect these long run
determinants of real GDP; thus, LRAS curve is vertical.

3. a) The AD curve would be more elastic. If, as Keynes suggests,

businesses respond less to changes in real interest rate, than the
investment demand component of aggregate expenditure will
respond less to the initial increase in price and thus the slope of
the AD curve will be closer to zero.
b) Monetary policy is used to either increase or decrease the
supply of money. A shift in the money supply curve to the right
would lower the equilibrium interest rate which would in turn
increase the consumption, investment demand, and net exports
and hence aggregate demand. If Keynes considers interest rate
to a weaker influence on investment demand, then lower interest
rates will not necessarily spur an increase in aggregate demand.

4. High interest rate elasticity of money demand, high interest rate

elasticity of investment demand, and a low percentage of firms
with sticky prices is the combination that would make monetary
policy most effective at influencing real output in the short run.
When the Fed either decreases or increases the money supply
through open market operations, a high interest rate elasticity of
money demand would result in the greatest change in interest
rate. This change in interest rate will spur the greatest change in
aggregate expenditure if the interest rate elasticity of investment
demand is high. Real output is determined by the intersection of
the SRAS and AD curve. A shift in the AD curve would have the
greatest effect on Real output when the SRAS curve is more
elastic. This occurs when a low percentage of firms have sticky
prices. Thus, this combination would make monetary policy most
effective at influencing real output in the short run.

5. a) See graph

b) See graph

c) In the short run, some firms respond to the increase in AD by

increasing prices while others just adjust their output. As we
transition to the long run, because of this partial increase in the
price levels, agents adjust their expectations of inflation
upwards. This change in expectations is one component of the
AS curve shifting back to the left.
 d) Nominal wages are sticky in the short run. Thus, nominal
wages at points A and B are the same. At point C, nominal wages
are higher.

e) Real wages at point B are lower than at point A. Real wages at

point C are the same as at point A.

f) Yes this is consistent with money neutrality since though real

wages are altered in the short run, they are unchanged in the
long run.

6. a) The housing market, in terms of levels of new construction and

real estate prices, have performed well in the last five to six
years. Much of this growth has been spurred by low mortgage
rates. According to the Bernanke article, the expansion of US
housing wealth has kept the U.S. national saving rate low and
increased the current account deficit. This is due to the
expansion of housing wealth, accessible through cash-out
refinancing and home equity lines of credit. This housing wealth
made homeowners feel effectively richer because according to
the permanent income hypothesis a consumers income is more
than just his/her disposable income, but includes both physical
and human assets such as property. Thus, when the increased
value of their home is factored into their consumption decisions,
consumers are likely to consume more and save less.

b) The US macroeconomy could suffer as a result of the subprime

lending crisis. Defaults on loans and foreclosures will result in an
increased supply in an already saturated housing market,
causing home prices to go down and leaving homeowners with
negative equity. The construction industry will suffer since
building new houses would not be profitable and consumers
would feel poorer as a result of the value of their homes
depreciating causing them to spend less. Thus, the real GDP will
suffer (both consumption and investment go down). This
particular housing slowdown is different from previous housing
slowdowns because the meltdown in the market for subprime
loans, made to homeowners with poor credit and carrying
interest rates 2-3% higher than normal loans. The default rates
of these loans have soared as the housing bubble has deflated
and some mortgage originators, such as New Century Financial,
are going bankrupt.